A 401(k) is an employer-sponsored retirement plan offered to many employees in the United States. Participants elect a percentage of their paycheck to defer toward their retirement savings in the plan.
401(k) plans have largely replaced employer pensions. Instead of a defined benefit at the end of a long working career, employees now control how much (or how little) to contribute to their retirement savings. A 401(k) plan comes with quite a few benefits.
Benefits of 401k
- Employer match
- Tax-advantaged savings
- High contribution limits
- A loan option
- Earlier penalty-free access
- Assets protected from creditors
- Exemption from the IRA Aggregation Rule
Many employers offer a matching contribution as a percentage of compensation for employees. The typical match is between 3% and 6%. It's basically extra compensation for employees that are smart about saving for retirement, however, the match often vests over a specified number of years of employment with the company.
Savings in a 401(k) are tax-advantaged. Depending on the type of account an employee sets up, their contributions may be tax deferred (traditional) or tax free upon withdrawal (Roth).
Additionally, dividends and capital gains within the 401(k) account never get taxed. That allows your investments to grow much more because the government isn't collecting taxes every time you make a transaction in the account.
High contribution limits
401(k) plans have the highest contribution limits of any retirement account. The employee deferral limit is $19,500 in 2020. If you're 50 or older, you can defer an extra $6,500 per year. Those limits far exceed an IRA, which is capped at $6,000 in 2020 with an extra $1,000 catch-up contribution for older savers.
On top of those standard deferrals, some 401(k) plans allow for additional after-tax contributions. Total contributions including employee deferrals, employer matching, and additional after-tax contributions are capped at $57,000 in 2020.
A loan option
Many 401(k) plans have a loan option, which allows account holders to withdraw up to 50% or $50,000 (whichever is less) from their account. The account holder has up to five years to fully repay the loan.
Note that failure to pay the loan back on time can result in additional income tax and a 10% early withdrawal penalty.
Earlier penalty-free access
Employees who leave their work during the year they turn age 55 or later can start taking withdrawals from their 401(k) immediately without penalty. Typically, employees have to pay an additional 10% tax on withdrawals before age 59 ½ in a 401(k) or an IRA. But separating from service in your mid- to late 50s can get around that.
Assets protected from creditors
Most creditors won't be able to get their hands on your retirement savings in a 401(k) account. There are a couple of exceptions: Ex-spouses can seek a share of 401(k) assets in divorce proceedings, and the IRS can come after your savings for unpaid taxes. But in the case of a lawsuit against you or if you need to declare bankruptcy, your retirement savings are safe.
Exemption from the IRA aggregation rule
One common strategy for higher-income households that don't qualify for a Roth IRA is the Backdoor Roth. They make after-tax contributions to a traditional IRA, and then rollover that contribution into a Roth IRA.
But if you hold tax-deferred funds in a traditional IRA, you'll have to pay additional taxes due to the IRA Aggregation Rule. You can't specify which funds you're rolling over into a Roth account. Instead, the IRS aggregates all the funds in your IRA accounts, and it determines the average tax status of the funds you rolled over. If you can move all of your tax-deferred funds to a 401(k), you can avoid that problem and reopen the back door.
A Roth 401(k) allows employees to make their paycheck deferral into a Roth account instead of a tax-deferred account. The employee pays income taxes on that money now, and they don't have to pay taxes upon withdrawal. Employees can also withdraw their contributions (but not their gains) without penalty at any time.